Feldstein on inflation

Martin Feldstein has an interesting Op-Ed in the Wall Street Journal, "Why the U.S. Underestimates Growth."

The basic idea is that inflation may be overstated, because it doesn't do a good job of handling new products. As a result, real output growth may be a bit stronger than measured.  Marty runs through a lot of sensible conclusions.

He doesn't talk about monetary policy, but that's interesting too. So what if inflation really is (say) 3% lower than we think it is, and therefore real output growth is 3% larger than it really is?


That would mean we are a lot closer to "normal" of course.

It would mean that we really have 0% nominal interest rates, 1.5% deflation rather than 1.5% inflation; +1.5% real rates rather than -1.5% real rates. That is about the ideal monetary policy. Flat nominal wages, so we don't have wage stickiness problems, slight deflation matching productivity increases and a positive but low real rate of interest. We live the Friedman optimal quantity of money. In addition, it means no inflationary distortions and fewer intertemporal distortions in the tax code -- no taxing interest.

The labor market is pretty much back to normal except for the labor force participation rate. The main sign of weakness is real output growth, and Marty suggests that might not even be there.

How should the Fed react? News that real output growth is stronger than the Fed thinks would be an argument to raise rates. News that inflation is weaker than the Fed thinks is an argument to lower rates. At conventional Taylor-rule parameters of 1.5 times inflation plus 0.5 times output gap, news that inflation is 1% lower and output is 1% higher means the lowering effect wins. So, in fact this is an argument to keep rates where they are and to continue basking in the Friedman optimal quantity of money for a while.

In fact, this strikes me as the main conclusion. As Marty points out, if real growth is stronger than we think, that doesn't mean it couldn't be stronger still. If real wages are really rising, that doesn't mean they couldn't be rising more. Weak labor force participation and total factor productivity are not much influenced by inflation measures.